going up or down?
April 30, 2011 PSW Staff
fundamentals and decide which stock or stocks we would like to get involved with,
technical analysis should not be overlooked. Looking at charts can be a good tool to
decide when to enter a trade, what sort of profit target you should have, where you
should keep a stop-loss or trailing stop-loss in place, and what sort of time horizon
makes sense. This will help you determine whether or not the stock that you have
chosen through fundamental analysis is a good fit for your own situation.
Unfortunately, technical analysis cannot tell you what direction the stock will go in the
future, no matter how much past evidence you have to work with. Think of it as being
exactly like forecasting the weather. One or two days out, weather predictions can be
fairly accurate, although not always. Look out five to ten days, however, and weather
predictions are almost always inaccurate. This is because more often than not,
trends continue from day to day. Add more and more variables, however, and more
often than not, things change.
So why do weather forecasters and technical stock analysts still have jobs? The
reason is that there is a ton of value in preparing for major changes whether or not
they actually occur. Lives can be saved and portfolios can also be saved when folks
are warned that catastrophic events are likely to occur.
The main problem with using technical analysis only is that you are making an
assumption that all information, whether it be public or private, can be found within the
charts. This includes information held by company insiders, market regulators,
suppliers, competitors and even employees and contractors or consultants, as well
as all publicly available reports and statistics. This predicates that markets are
always 100% efficient, and assumes that greed and fear can be quantified.
It can be proved that the current price of a stock is not 100% efficient. Just take a look
at companies filing for bankruptcy. Had the price been efficient prior to, then the stock
would not have fallen by 80% overnight. And if you think that insiders had no idea of
the impending doom, perhaps you would be interested in some ocean front property
in Arizona? You can also bet that the “gap” created overnight will never be filled.
Despite all of this, charts are still great tools. We use candle stick charts, not
because they show neat little patterns that have cool names, but because they
contain more information than a standard line chart. Charts include everything you
need to know about the past activity of a stock. How close is it to a one or two-year
high? What has been the biggest one day move, or the smallest? Has trading activity
been rising or falling? These simple visual observations can make a huge difference
with respect to having realistic expectations.
Stocks that are moving up are a tiny bit more likely to continue moving up, and stocks
that are moving down are a tiny bit more likely to continue moving down. This is
where fundamental analysis is key. As the stock has been moving up, has it become
overpriced? What has happened to the P/E? If the stock has been moving down, has
it become cheaper? Has the price fallen while earnings have not?
Lets take a look at a popular technical analysis phenomenon known as bullish and
bearish engulfing candlesticks. This occurs when a stock moves in one day, or
whatever the period of the chart, by an amount that exceeds the movement of several
of the previous days or periods movements. If that larger candle is green (finished
the day higher than where it started), it is considered bullish, and if the candle is red
(finished the day lower than where it started), it is considered bearish. Do we really
need fancy names to tell us that a stock seeing a large one day gain is a bullish
phenomenon, or that a stock seeing a large one day decline is a bearish one.
Again, value does exist in technical analysis. When a stock has a large one day gain,
yes, it is likely to continue higher, but what is this a function of. Look at the news, read
the reports, if the only reason for the advance was technical, maybe there is some
insider info that can be gained. Just be sure you realize that insiders, just like most
humans, will always look out for themselves first.
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